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M&A Landscape 2012 - More Deals to Come

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By: Kenneth Marks By: Kenneth Marks

The global market for companies with revenues between $5 million and $1 billion, the bulk of which are less than $500 million, is on track to exceed every year in recent history except 2007 in terms of the number of reported deals; over half of these transactions are with companies with revenues between $5 million and $150 million. From the December Issue.

In terms of aggregate value, the market is estimated to have increased about 20% over 2010, with valuations for private equity transactions between $100 million and $250 million currently exceeding those of the peak in 2007.  In the U.S. there are about 300,000 companies that fall within this segment, primarily owned by baby boomers, Gen Y’rs and private equity funds.  So, what does the landscape for 2012 activity look like? 

First, let’s take a look at what’s driving the market, some of the challenges facing middle market businesses, and the opportunities to be considered.  While on the surface deals may appear to be similar to earlier waves of M&A activity, underneath the hood these transactions are of higher quality and have generally been vetted with significant scrutiny.  The bar has been raised.

M&A and the private capital markets currently present an interesting set of alternatives.

Market Drivers –
These are the key factors that are influencing the current market activity and that are likely to drive deals in 2012: 

Large strategic buyers, represented by the S&P 500 and Fortune 1,000 companies, are seeking revenue growth and access to new customers, all in an effort to deploy record amounts of cash hoarded on their balance sheets and to increase stock prices.  Middle market companies represent a fertile hunting ground for higher growth niche businesses fulfilling the needs of the large strategics without taking the risk of having to do bigger, bet-the-farm deals. Private equity investors have several challenges that will drive the middle market in 2012.  During the past five years private equity funds have amassed a war-chest of capital that is now more than $500 billion.  The combination of too much capital and too few well-managed companies to investment in, coupled with the need for exits for their earlier vintage funds, will create a wave of M&A opportunities.  

Baby boomers are aging and thinking about diversification and retirement, increasing the number of companies desiring a sale or seeking a transition of ownership.  The Gen Y’rs are building businesses with the expectation of exiting within a relatively short period of time.  Combined, these create a pent-up supply of companies for sale.

Financial market uncertainty continues to cause anxiety for many shareholders of middle market companies.  Expected changes in capital gains tax rates, lack of available credit, increasing government regulation and sluggish overall economic growth make it difficult to project the future and develop credible growth plans.  The result for some owners is a desire to lock-in value today at known values versus risking an unpredictable outcome later.

The Challenge –
Not long ago, owners of middle market companies could expect to sell their business at a reasonable value when they were ready for a transition.  Their business didn’t have to be the best performer, but rather operate comparably to the performance of their peers in meeting decent middle-of-the-road metrics.  Not so today. Many owners are experiencing what the market is calling the “Value Gap”.    

The essence of the front-end steps in the M&A and financing process is an analysis and understanding of the shareholders’ and company’s objectives, financial and competitive position, growth strategy and initiatives, and valuation.

This gap manifests itself in a number of ways in terms of buyer interest, access to growth capital and valuation.  In many instances, it’s not a matter of the value of the company being low or the cost of capital being high. It is, rather, the absolute lack of any interest in financing or acquiring the company at all. 

For example, lower middle market businesses that haven’t yet hit their stride or met their potential, as evidenced by slow growth rates, low gross margins or low EBITDA margins, but are strategically positioned to attract buyer interest, have seen a continued declined in EBITDA multiples paid by both strategics and financial buyers.  On the other hand, the higher-performing middle market companies with EBITDA greater than $8 million to $10 million are experiencing record high multiples, even higher than those in late 2007 and early 2008.  Simply put, the size of EBITDA does matter.

The value gap can be illustrated by the wide difference between what is referred to as “Owner Value” and “Market Value”.  Owner value is the required value in the M&A transaction by the shareholders of the selling company, whereas market value is the range of amounts that the market players place on a company based on their perspective and the market dynamics.   In many cases, owner values have been driven higher by the lack of alternate investment opportunities post-closing that will yield returns with adequate cash flow to mirror those that the owners currently experience by holding their interest in their business.  In many situations, market values for all but the high performers have been driven down. Thus, the gap has widened.

Recent research and empirical evidence show that the root problems causing this value gap for middle market companies are twofold:

  • Companies don’t generate returns adequate to cover their cost of capital, and
  • Management isn’t re-investing at an adequate rate to sustain growth AND remain competitive and relevant in the market place long-term.

The Opportunities –
M&A and the private capital markets currently present an interesting set of alternatives.  As shareholders contemplate the effect of the market dynamics, their companies’ growth strategies and eventual transition plans, some are seeking deals that allow them to:

  • Diversify away the risk of having too much personal net worth in a single asset.
  • Minimize the risk of growth by obtaining a financial or strategic partner.
  • Buy-out passive partners and make room in the capital structure for management and employees without dilution to exiting active shareholders.

So, depending upon the strength of the middle market business, its strategic position, and its financial performance relative to peers, the spectrum of options can include:

  • Selling to a strategic or financial buyer – the stronger, or “A,” players in the market will likely have the opportunity to sell their business in whole or part through a traditional buyout transaction that can provide a change of control, selling the majority of the business to a private equity fund while keeping a minority portion.  The advantage of this approach allows the current owners a “second bite at the apple,” using the fund’s capital to further grow their business and the opportunity to sell a second time when their investor sells (some three to five years later).  Strategics provide the opportunity for a complete exit at a price that the financial buyer may find difficult to match because of the inability to obtain a return outside of the pure financial metrics.
  • Acquire or merge with a complementary or competitive player – there are various forms of acquisition financing available depending upon the relative strengths of the parties.  Because of some of the structural barriers in the private capital markets, a lower middle market company may not have access to growth equity or mezzanine financing alone.  However, through an acquisition or merger two businesses with the right synergies and combined cash flow may very well cross into the credit box or investment criteria that allows the newly formed business access to capital to accelerate growth, fund strategic initiatives and possibly buy out some partners or shareholders.
  • Recapitalize the existing business – generally a recapitalization will involve a lower cash-out (as a partial or staged exit) for the active owners than a buyout (which involves a change of control).  A recapitalization will most likely be focused on changing the relative mix of debt and equity with an eye toward the growth objectives of the company and the required go-forward capital.  For example, a leveraged recapitalization will most likely increase the debt of the company in exchange for distributions, dividends, or purchase of equity.

Focus on value creation –
Regardless of the eventual solution or desired outcome, start with the same process.  The essence of the front-end steps in the M&A and financing process is an analysis and understanding of the shareholders’ and company’s objectives, financial and competitive position, growth strategy and initiatives, and valuation. 

Keep in mind that whether selling the entire company, raising a tranche of growth capital (in the form of debt or equity), or pursuing a recapitalization, what you are really selling is the future cash flow of the business.  While past performance provides credibility to management’s claims, future cash flow is the foundation for valuation and usually the primary reason for buying or investing in a company.

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